Amid Sequester, US Defense Stocks Still Surge

Jun. 1, 2013 - 03:02PM
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WASHINGTON — Signs of the automatic budget cuts known as sequestration are everywhere in Washington, but on Wall Street it’s a different story.

Many US defense stocks are at or near record highs, having well outperformed the broader market recovery of 2013, and much of that gain occurred in May.

While the S&P 500, a capitalization-weighted index of top US companies, grew 3.4 percent from April 29 to May 29, defense stocks nearly doubled that figure at 6.5 percent as measured by the Spade Defense Index (DXS).

The Spade Defense Index, also capitalization-weighted — meaning that the index factors in the value of the companies when aggregating numbers — is composed of nearly 50 companies, more than two dozen of which appear on the Defense News Top 100 contractors list.

Goldman Sachs even announced May 30 that it now considers defense stocks “attractive,” a move that will likely push more casual investors into the space and spur more growth.

That growth, paired with the fact that defense stocks didn’t tumble when the sequester became official, means that defense contractors are experiencing stock pricesat or above previous highs of 2007 before the economic downturn that served as a drag on the market as a whole.

“The sector never really dropped, it never really collapsed even when people thought it might,” said Scott Sacknoff, manager of the Spade Defense Index, discussing both the index and the PPA investment fund that is built on the index. “The index is higher than it’s ever been, which means that we actually have a higher valuation of defense companies now than we did when we hit the peak in defense spending during the Iraq and the Afghanistan wars. I’m really not sure what to make of that.”

Part of the reason for the strong defense market has been a lack of dramatic news in the first stages of the defense sequester, said Byron Callan, a market analyst with Capital Alpha Partners.

“At the margin, the news has been less bad on sequestration and the budget deficit, but I don’t think anything in the underlying picture has really changed,” Callan said.

That the fundamental conditions of defense haven’t changed doesn’t matter to many of the investors moving into the marketplace, he said.

“It’s seemingly very shortsighted, but with an average holding period in the market of only six months, it’s all relative,” he said.

In the short term, defense companies have been announcing solid returns during the recent earnings season, and are pushing to increase both share repurchases and dividends, making those categories climb from roughly one-third of cash deployments to two-thirds in the last couple of years. That’s an attractive value proposition for investors, and may be part of why the sector has been fairly resilient despite looming budget cuts.

“Washington, D.C., is thinking about the sequester rolling through and what will happen in the next few years. Wall Street is so shortsighted that they’re worried about May of 2013,” an industry executive said. “They want yield, and defense contractors tend to gush cash. We know that they’re not going to do anything foolish since the industry is already over-consolidated. It’s a really safe place to go.”

Worth noting, however, is the fact that the volume of trades is down about 30 percent from their peak. Normally, growth occurs because of a rush of investors into an area, but that doesn’t appear to be happening yet in defense, although the Goldman Sachs news may change things.

“You probably have a core group with institutional investors who believe that defense is an important part of their portfolios,” Sacknoff said.

Those core investors were also unlikely to sell off stock on news of the sequester because of their broader view of the defense market, Sacknoff said. “I think you’ve got a lot of hands who have been in defense and will always be in defense. So if they sold it they’d have to pay taxes on it,” he said.

But while news in the defense sector has been good thus far, with Defense Department cuts largely sparing programs, that likely won’t continue, Callan said.

“The irony is that we really haven’t gotten into the full sequester yet, it’s off on the ridge line, it’s not in people’s thinking.”